Traditionally, the securities markets have not been hospitable to individual investors. This is especially true of the bond market. Bonds exist in minimum units of $1,000 principal amount for taxable bonds or $5,000 for municipal bonds. It is essentially an over-the-counter market, i.e., there is in practice no central exchange for bond trading. The prospects of a national bond exchange are dim in view of the fact that broker dealers are presently enjoying large profits through the status quo. Moreover, except for U.S. Government securities, bond price quotes are only readily available to brokers and dealers. While some bonds trade on the New York and American Stock Exchanges, such trading is limited to listed issues, of which there are very few corporate bonds and no municipal bonds or Treasury bonds. Fewer corporations are now listing their bonds, even though the listing service is free to stock-listed companies.
As a group, individual investors have an enormous asset base. However, trading by individual investors is fragmented among relatively tiny pools of money, resulting in small trades of $5,000 to $10,000. The individual investor attempting to execute a $10,000 trade must compete with million-dollar institutional orders, particularly in the bond market. At this size of trade, pricing for, and availability of, bonds is unattractive and therefore trading and participation by individual investors in the bond market is relatively infrequent. While there exists an active “odd-lot” market, that is, a less-than-institutional sized market, for individual bond trades, the choices are limited (e.g., choice of issuer, credit rating, maturity, interest rate, call protection, etc.) unless the investment is an “individual round lot” of $100,000 or more. Even at this larger size of trade, however, attractive prices and bond selection are not assured. For individual investors, the spreads are large, with 2 to 6 points (i.e., % of principal amount) being common, and, when coupled with commission charges, the return-on-investment (ROI) can be significantly compromised. In addition, the time for execution ranges on the order of days rather than seconds as in the more liquid equity markets.
Individual investors have the same fixed costs in trading bonds as institutional investors. Trade-processing costs average about $50 per trade, regardless of the size of the trade. For a $1 million trade, this cost is negligible. But for a $5,000 trade, such costs constitute a full point before considering the spread. Such costs have also discouraged trading and direct ownership of bonds by individual investors.
Accordingly, the typical investors in the bond markets have been large institutional investors, primarily pension funds, mutual funds and insurance companies. With asset pools of $100 million or more, such institutions can trade regularly in amounts of $1 million or more. Both the corporate and municipal markets are highly liquid for institutional investors, with bid/offer spreads being on average ⅛-½ points in price, depending on maturity.
Another problem with the current securities markets is that there is currently no vehicle by which securities holders may readily trade securities, or fractional shares thereof, directly with one another. Buyers and sellers must, therefore, use an intermediate broker and incur the high fees and costs associated therewith. As discussed above, such fees and costs can be prohibitive, particularly when relatively small transactions are involved. Furthermore, as there is no central exchange for bonds, it may be difficult for a buyer who is seeking to purchase a specific bond to locate a seller who is selling that specific bond. This is particularly true when only a small number of bonds, or a fractional share of a bond, are at issue. Thus, the bond market is an illiquid market in that even if an investor is able to purchase a small number of bonds, or a fractional share of a bond, that investor may not readily sell such bonds if cash is quickly needed or desired. Ownership of bonds, therefore, has not been regarded as an attractive alternative to cash-on-hand for the individual investor.
A further problem with the current bond market relates to longstanding securities industry regulations which require that the firm through which the trade is made ensure that the customer's investing activity is suitable for that customer based upon the customer's financial situation and investing expertise. Traditionally, these regulations have been met by intermediate brokers by manually reviewing and approving each trade prior to settlement. As far as the inventor is aware, this approach continues today with known Internet-based trading systems, such as those made available by E*Trade, Charles Schwab and Fidelity, with back office staff reviewing each order and manually approving same. Such manual review and approval increases the costs associated with securities trading.